THE EVOLUTION OF the use of derivatives by corporations in Latin America has not been straightforward. The fallout from the spectacular misuse of FX hedging products by some Latin American corporates continues to throw up practical and psychological barriers.
In Brazil, the largest market and comparable only to Mexico in the adoption of risk management trades by corporates, the regulators have just introduced another macro-prudential measure that targets FX derivatives. Confusion still reigns about exactly what the new decree means.
What is clear, though, is that the latest Medida Provisória will be an impediment for many corporate FX hedging activities. For now, markets that need to grow in the region, such as interest rate options and onshore credit default swaps, are awaited more with hope than expectation.
Hangover from 2008
The crisis of 2008 created many losers but perhaps none quite so high profile as some of the Latin American companies that got exposed on currency derivatives. Essentially, companies such as Brazilian food processor Sadia, pulp maker Aracruz and Mexican retailer Comercial Mexicana (known as Comerci) had entered into non-deliverable forwards, target forward agreements and currency options that for many quarters were delivering revenues to the companies.
In the fourth quarter of 2007, for example, Sadia reported R$375 million ($235 million) accounting profit from these trades. CFOs began to see their emerging markets as a safe one-way currency bet: how could their currency stop appreciating against the dollar? The answer came swiftly and dramatically. The 2008 global crisis initiated a flight of capital to safe havens, funds flowed out of emerging markets and the region’s currencies plunged.
The currency tide went out and those who had been swimming naked in the FX market were clearly visible. Sadia lost R$3 billion in 2008 and Adriano Ferreira, the company’s CFO at the time, was fined R$2.6 million and barred from managing public companies for three years. Sadia’s chairman and vice-chairman also lost their jobs. Meanwhile, Aracruz announced derivative losses of more than $2 billion and Comerci told counterparties that it could repay just half of its $2 billion losses.
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“Bad risk management practices from CFOs who traded against the street were what brought down those few companies that were affected” |
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With such high-profile casualties it is not surprising that there is a reticence among some to propose new, sophisticated FX derivative programmes. “The memory of those companies that lost money in 2008 is still vivid among today’s CFOs, especially on the FX side. There are new products and the banks are willing to trade but many CFOs are very, very cautious,” says Francisco Freitas de Oliveira, head of Americas FX and FX hybrids trading at BNP Paribas in New York. “What’s difficult is that everyone remembers the 10 or so that were affected, but people forget that several other companies did very well out of their FX hedging, despite the downturn, because their hedges were properly aligned with their FX exposures. But because of the memory of a few bad cases the finance directors aren’t pushing too much for internal approval for the second-generation instruments.”
Regulators responded with greater efforts to monitor the corporate sector’s exposure to derivatives (the impact on the banking systems had been minimal as they were already tightly regulated). Companies that had been trading with up to 10 banks at a time are now required to disclose all trades to the regulators so they can see each company’s net exposures.
Banks, too, realized that they had been entering trades with companies that made sense for the individual corporate’s underlying exposures but had been unaware their clients had similar positions with nine competitors. “Bad risk management practices from CFOs who traded against the street were what brought down those few companies that were affected,” says BNP Paribas’ Oliveira.
“In almost all of the cases, it was one client against several different financial institutions, so even the banks didn’t have an accurate picture. In most Latin American countries today we still don’t have a legal right to see a client’s overall exposure – Brazil being the only exception pushing for consolidated derivative exposure reporting that can be accessed by banks if the client allows. But what has changed is that global banks are imposing stricter credit support annex agreements (CSAs) with collateral margins. We are now working with clients who accept more prudent CSAs because their derivatives are related to real risks.”
Regulatory impediments
Medida Provisória 539, introduced in Brazil on July 26, is, however, not a regulation aiming to improve the efficiency and transparency of the derivatives market. The measure enables the Brazilian National Monetary Council to establish a maximum rate of 25% for a foreign currency inflow (IOF) tax levied on the trading of FX derivatives, as well as compulsory deposits of up to 100%. The government in effect took a snapshot of the market positions as of July 26 and then immediately levied a 1% tax on any new derivative positions (the currency derivative market in Brazil is much larger than the spot market).
The government moved to counter what had been the continuing appreciation in the value of the real against the dollar. “We are going to make speculation less profitable with all these measures,” said Brazil’s finance minister, Guido Mantega. “We are in the middle of a currency war. Imagine if no measures had been taken – the dollar would be even lower.” However, there is confusion among market participants about how exactly the tax will be levied and collected, and some question whether or not the regulation can be implemented without clarifying regulation.
Mantega claimed that the new tax would only affect speculators and would not have an impact on “defensive” hedging strategies of Brazilian exporters. However, bankers say that corporations’ ability to source FX hedges has deteriorated as several Latin American countries embarked on currency wars, imposing regulatory and tax frictions to FX trading, both in cash and derivatives instruments. This has led to dislocations on the pricing of onshore and offshore instruments and has created further burdens for legitimate hedging from corporations and institutional investors.
Brazil’s recent measures regarding tax on derivatives have increased the difference between onshore and offshore spreads in the FX markets, leading to a reduction in the volume of FX derivatives transacted in local markets at BM&FBovespa and a partial migration of the volume to offshore OTC markets, such as the CME, which is seeing a record volume in real futures in 2011.
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“There is a lot more government interference in markets across the world so it’s not a phenomenon specific to Brazil” |
“For transparency and prudential reasons that’s a worsening of the status quo,” argues Tony Volpon, head of EM research for Nomura in New York. “The difference in the basis also creates incentives for anybody who can buy offshore dollars and sell onshore dollars for arbitrage. They have to run the basis risk but depending on how you can account [Brazilian accounting regulations can enable companies to split out components of OTC and recognize losses in some cases] for that, it’s a pretty good basis to run and what is being created is an incentive for corporations to issue more dollar debt. And because companies can offer cheaper onshore dollars, it creates an incentive to do things like intra-company loans.”
The real has gained about 8% against the US dollar this year, following a 4.6% gain in 2010 to hit a 12-year high just before the new IOF tax was introduced. The real weakened nearly 2% on the news but the economic crisis surrounding the US downgrade has complicated interpretation of the new regulation’s effect. “The crisis has meant that people have been buying dollars, so people are moving away from the levels established by the government’s snapshot, meaning this new constraint has become a binding constraint,” says Volpon. “But in the few days following the measure when the external volatility wasn’t a factor the market was totally dead: no one was quoting derivative prices and those who were quoting were just putting the 1% tax on as a cost.”
As well as adding friction to the functioning of the FX derivatives market, the new measure is another demonstration of enthusiasm for so-called macro-prudential measures that are widely unpopular with bankers. “We live in new times and there is a lot more government interference in markets across the world so it’s not a phenomenon specific to Brazil,” says Volpon. “Unfortunately the IMF has given this interference philosophical validity – it has almost blessed actions like this in a variety of papers that it has published in recent months that say, albeit with caveats, that it’s OK to take measures like this. You are opening Pandora’s box and creating an environment where these things are acceptable. The IMF is legitimizing a view that markets are irrational, that they overshoot. Then Brazil launches a measure like this and nobody really says anything.”
Banks seek beyond vanillas
Despite the obstacles, hedging FX risks is becoming something companies are keen to do. Dan Silber, deputy head of global markets at HSBC in New York, says HSBC was the first bank to offer clients the ability to trade reais against renminbis on a deliverable basis and in 2010 opened a LatAm coverage desk in Hong Kong managed by professionals from HSBC’s São Paulo office. The aim is to capitalize on the growing south-south trend in international trade and be there to support and advise clients as they develop these new trade routes. But flow for flow’s sake isn’t HSBC’s ultimate goal; rather, Silber says, he is trying whenever possible to elevate client dialogue to a strategic level.
He says: “We love being a flow house but we don’t solely want to be a flow house. We have been involved in many more strategic dialogues in the past two years than ever before. Historically, I would say that clients were primarily interested in our balance sheet and the financing we could provide. While they remain interested in that and we are happy to provide it, they see us as a solutions-orientated adviser with the ability to bring a high level of content to the conversation.”
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“We are happy to do a plain vanilla hedge but we’re not going to differentiate ourselves in that trade – any number of banks can execute that” |
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By way of example, Silber points to a large Mexican conglomerate that was buying a Chilean pharmaceutical company. HSBC advised on and financed the deal but was also brought in to manage the exchange rate exposure. “It was a complex hedge because there was deal risk, risk of appreciation of the Chilean peso between the time of the bid and the time the deal was completed and an ultimate need to deliver Chilean pesos,” says Silber. “Few banks are able to provide the financing and then marshal resources across three countries to deliver a customized exchange rate solution in what many perceive to be a relatively illiquid currency.” Silber adds: “We are happy to do a plain vanilla hedge but we’re not going to differentiate ourselves in that trade – any number of banks can execute that.” However, Andre Hubner, head of global markets for HSBC in São Paulo, says that larger global banks have an inbuilt competitive advantage when it comes to executing derivative strategies that support large M&A deals. He points to a 2007 Brazilian acquisition by an Asian steel company when the amount of FX trade was equal to three days of volume traded in the market. “Even though it was a vanilla transaction, the strategy of placing this in the market before the actual execution of the M&A helped the company to diminish and manage its future exposure to the market – and in that case once the news hit, the market moved and the client would have lost a portion of the value of the deal if he hadn’t been hedged prior to the announcement,” he says.
Scale also brings access to potential areas of unnatural liquidity. Banks with access to potential corporate counterparties in different industries throughout the world can at times create two-sided hedges that are more cost-effective for both parties than going through the market.
Non-FX hedging
Of course, it is not just FX for which companies require hedging. Companies in the region also seek to mitigate their exposure to commodity volatility, although according to Oliveira, outside the large producers (such as Petrobras and Vale) most regional commodity trades are related to hedging project-specific (rather than enterprise-wide) revenues: “The main focus is on deals that are greenfields, or project finance where the sustainability of those deals would rely on certain price levels of the underlying commodity, be it copper or sugar”.
Interest rate hedging is also growing – with volumes and liquidity in interest rate products and swaps strong, with some corporate interest in these products reported. There are also smaller packets of activity in customized products. For example, some Brazilian companies borrow long-term from Brazilian development bank BNDES, paying a floating interest rate called TJLP plus a spread. TJLP is set by the government every quarter and is a cheaper funding rate than other real alternatives. There is no interbank market for the TJLP so the liquidity for the market on TJLP derivatives is very low. But some banks can provide a hedge for those clients and they can swap these TJLP liabilities into other indices (eg the CDI) that are more liquid. It’s a very customized solution for local rates clients – and the swap looks good when contrasted to the CDI, for example.
Banks such as HSBC, which is active in this area, are able to do this because of a diversified client base. The natural counterparties for this risk are corporates that don’t have primary access to funding from BNDES but want to borrow in TJLP. The bank then swaps those liabilities out of corporates financed by BNDES (for example), and then offers that liability to corporates that wouldn’t have access to TJLP otherwise.
However, while bankers report that liquidity in interest rate futures in Brazil and Mexico is comparable to that in the G10, liquidity, market knowledge and price discovery on interest rate options are 10 years behind the US and Europe, largely because of internal risk limits on their use. “That’s the sector I believe will result in exponential growth as the economic cycle continues,” says one banker.
The other market that is tipped for growth is the onshore credit derivative market, which would likely be used by large corporates, as well as institutional investors and financial institutions. The inability of an onshore credit default swap market (for example) to develop is largely the result of another derivatives hangover. It is the havoc wreaked by CDS in the US and Europe during the credit crunch that has reportedly left Latin American regulators cold on regulating them into onshore life.
“It’s not just the stigma, it’s ignorance on behalf of the regulators,” says a banker who would dearly love to see an onshore market for CDS in Brazil. “They are not up to speed on the revolution that has taken place in the CDS global markets – especially on the standardization of the contract, which is now fungible. I was a CDS trader in the 1990s and when I see them now I say ‘Wow’. They’re almost like semi-futures. But it will come. The sheer size of Latin America and its big economies means they can’t avoid what’s happening elsewhere.”
